Should companies be paying dividends right now?

COVID-19 has brought the apparent trade-off between shareholders and society to a head.

by Alex Edmans
Last Updated: 07 May 2020

In the midst of a global pandemic, many companies are correctly focusing on society, by paying furloughed employees, donating products, and prioritising the most vulnerable customers.

But investors are reminding companies of their responsibilities to them. The Investment Association wrote to all FTSE chairs stressing that “dividends are an important income stream for pension funds and charities, as well as ordinary savers and pensioners … shareholders would be concerned if companies unnecessarily reduced or rebased the dividend level.” The FT’s Lex column cautioned that “if all UK businesses stop paying dividends, the impact would be dreadful.”

So companies seem to be caught between Scylla and Charybdis. If they focus too much on employees and customers, they risk seriously harming their investors. It seems that they might have to let some workers go, to protect the dividend.

But this thinking violates a fundamental principle of Finance 101, known as the “free dividends fallacy”. Paying dividends does not increase shareholder wealth, because a dividend of £1 simply reduces the stock price by £1 – just as withdrawing from your bank account gives you more money in your pocket, but less in the account. Pension funds absolutely must satisfy their obligations to pensioners. But they can do so by selling their shares – and they can sell them at a higher price if the company cut its dividend.

Take a pension fund that needs to raise £1,000, and owns 1,000 shares worth £10. If the company pays a £1 dividend per share, the fund’s needs are met. But the share price falls to £9, so its holdings are now worth £9,000. If the company scrapped the dividend, the stock price remains £10. The fund could sell 100 shares for £10 to raise the £1,000. It’s left with 900 shares worth £10 each – so its holdings are again £9,000. Investors can always meet their liquidity needs by selling shares. They don’t need the company to meet it for them by paying dividends.

“Ah”, an investor might respond, “I remember that Miller-Modigliani principle from my finance textbook. But real life isn’t a finance textbook. The Miller-Modigliani assumptions don’t hold in the real world."

That’s true. The assumptions are normally violated, so dividends are normally good for shareholders. But – critically – these assumptions may actually ring true in the crisis, meaning we’re back to dividends not affecting shareholder value.

One key assumption is that CEOs maximise value. In the real world, some pursue self-interest. If they didn’t pay out spare cash as dividends, they’d waste it on corporate jets. That’s a legitimate concern in normal times, where firms have enough cash to take all profitable projects, and so further investments may be wasteful. But, right now, companies are cash-strapped. They can’t even pay their workers, let alone make value-creating investments. They’re highly unlikely to waste the cash savings from dividend cuts.

Another key assumption is that CEOs have the same information about their company as investors. In the real world, they’re better informed, and a CEO who knows that his or her firm’s outlook is good will want to communicate this. Raising the dividend is a credible signal, because only if the firm’s future is truly rosy will it be able to sustain the new dividend. Otherwise, the CEO would have to cut it later and see the stock price torpedo.

But a CEO only has superior information about a firm’s internal factors. In a crisis, most of a company’s value is driven by external factors – government policy responses and whether the curve is flattening out – where the CEO has no special insight. Internal factors – how hard his or her firm has actually been hit – still matter but are less important. No company will be able to credibly signal that it’s resilient by paying a high dividend. The only thing it will signal is how out of touch the CEO is.

That’s where investors have a part to play. They need to communicate to boards that they realise that the world is now different. The reasons why, in normal times, they justifiably favour dividends, no longer hold true. Investors claim not to use box-ticking approaches to evaluate companies. Now is the time to step up and show this, by not greeting a dividend cut with the usual – and usually-warranted – negative reaction.

A responsible business absolutely needs to serve shareholders, in addition to wider society, because shareholders are a critical part of society. But a landmark theory shows that serving investors need not mean paying dividends. And this is a time when the theory actually rings true.

Alex Edmans is professor of finance at London Business School and author of Grow the Pie: How Great Companies Deliver Both Purpose and Profit, published by Cambridge University Press.

Image credit: Sean Gladwell via Getty Images

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